The Accounting Mirage Behind Bank of America’s Blunder

Reading a public company's financial reports is a bit like walking down Disneyland's Main Street U.S.A. While everything looks and seems real, the truth is that it's largely a mirage. Investors in Bank of America (NYSE: BAC) were given an unpleasant reminder of this on Monday, when the bank suspended its recent dividend increase after uncovering an accounting error that stemmed from its 2009 purchase of Merrill Lynch.

The issue concerned so-called structured notes. If you don't know anything about these, you're in good company. In short, these are hybrid securities that include different types of financial products -- say, a stock or bond plus a derivative. In the present case, according to The Wall Street Journal, the notes were bonds with set maturity dates paired with related derivatives. The purpose behind commingling products like this is to change the risk profile -- that is, to make the underlying securities more or less risky and thereby increasing or decreasing potential return.

In this case, it appears that Merrill Lynch issued the structured notes sometime before its acquisition by Bank of America. The notes were essentially debt -- or, more analogously, bonds -- used by the formerly independent investment bank to fund its operations. The catch is that as Merrill Lynch's credit rating improved or deteriorated, the value of the notes fluctuated as well. When its credit improved, the notes lost value. When its credit deteriorated, they gained value. I know that sounds counterintuitive, but you'll just have to trust me that this is how it works.

The important point to appreciate is that most of these losses aren't actual expenses that result in a cash payment. If you've ever read through the earnings release of a large bank, then you've likely come across this. Without fail, virtually every quarter includes a debit or credit valuation adjustment that large banks back out of earnings in their presentations to shareholders. In the fourth quarter of last year, for instance, JPMorgan Chase (NYSE: JPM) reported a decrease in net income of $1.2 billion from "funding valuation adjustments and debit valuation adjustments." Meanwhile, Bank of America's adjustment reduced its 2013 earnings by $600 million.

Here's a hypothetical example of how this works: Say Merrill Lynch issued $100 million in structured notes in 2004. One year later, its credit improves, causing the value of those notes to decline by 10%. While Merrill Lynch must realize the $10 million decline in the equity portion of its balance sheet, the loss isn't recognized for tax or other purposes until it actually offloads the position at a discount. Moreover, because these securities are typically held to maturity, all the intervening fluctuations in value are canceled out, leaving the bank with neither a realized nor a recognized loss.

However, the problem in this case was that Bank of America did in fact take dispositive action with some of Merrill Lynch's structured notes but nevertheless continued to treat the valuation adjustments as if they were both unrealized and unrecognized. According to the bank's press release issued on Monday (emphasis added): "The company correctly adjusted for the cumulative unrealized change on structured notes accounted for under the fair value option, but it incorrectly adjusted for cumulative realized losses on Merrill Lynch issued structured notes that had matured or were redeemed by the company subsequent to the date of the Merrill Lynch acquisition."

The takeaway here is that shareholders need not worry about Bank of America's financial health. Its latest revelation, while likely to impact its formerly announced capital allocation plans, has little if any actual bearing on its past or current performance. Instead, what we're talking about are essentially paper losses -- and ones that date back to Merrill Lynch before the crisis. Does this excuse the error? Absolutely not, as Bank of America holds $2 trillion in assets and can thus afford to hire the best and have a zero-tolerance policy for mistakes like this. That being said, at least as far as we can tell, it does appear to have been a mistake and nothing more.

The little $20.8 trillion secretBank of America's couple-billion dollar mistake is nothing to the pressure they face in the worth of competition from this upstart. To learn about about this company, click here to access our new special free report.

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You got it backwards, a note will not decrease in value as the credit improves, it will increase. However, an increase in the note will be an unrealized loss to the issuer as it will have to pay more at the market value to buy back the debt.

I am interested if this only affects the regulatory capital and not the GAAP balance sheet. It seems the former as the latter wouldn't balance if they did it properly.